Hedging Renewable Fuels: Managing Risk Without Destroying Value

The multiple commodities used in biofuel production introduce complexity and challenges to designing effective hedge programs.
By Randy Wilson, Brian O'neal, Evan Zuckert | April 15, 2010
Hedging renewable fuels introduces a strategy and risk management complexity that is unusual even for experienced energy risk management professionals. Ethanol production requires three major commodity inputscorn, dried distillers grain (DDG) and natural gas. They are each used in varying quantities, purchased and sold in different markets, traded on different exchanges (if at all) and vary in their correlation to each other as well as to related energy commodities (such as heating oil and gasoline). Plus, when adding in the more macroeconomic factors that influence ethanol margins such as tax incentives, asset valuations and access to capital, the hedging story becomes quite interesting indeed.

The solution to managing through this complexity is to keep the initial hedging approach relatively simple with a program that is both flexible and scalable in terms of transaction volume and complexity. It is imperative that hedging decisions are derived from a sound analysis of the company's financial risk profile and capital resources.

Risk Identification and Measurement
To start, identify and quantify all sources of market risk. Every company's risk profile will be different based upon assets owned, contracts involving these assets and how they are deployed. If you have not previously hedged much, do not initiate a program by hedging 80 percent of corn purchases, 100 percent of natural gas and 90 percent of expected ethanol production for the next two years. Instead, start with small volumes for shorter durations, perhaps 20-30 percent of anticipated purchases and sales for a period not exceeding the next business cycle or season (six months). This accomplishes two very important things:

>The impact of hedging on key financial metrics can be assessed without significantly altering the company's financial position.
>It provides time for accounting, tax and credit departments to establish procedures to support the overall hedging effort. Issues around valuation, invoicing and collateral can be worked out on a smaller scale where errors are less likely to be financially material.

Before executing a hedge strategy, back test against historical data by creating a spreadsheet that examines key financial metrics under different hedging scenarios over the past one, three and five years. While the past will obviously not predict the future, certain factors, such as seasonality or periods of high price volatility should be visible, with the impact on cash flow and returns readily observable. Finally, determine an acceptable amount of market risk, and express it in financial terms that resonate with leaders of the business.

Risk Strategy and Tolerance
Use simple hedging instruments that you understand and, more importantly, that achieve the targeted price risk and exposure objectives. Many ethanol producers favor over-the-counter (OTC) swaps, indexed to CBOT ethanol. OTC instruments may not require a company to post margin and the price should correlate well with the physical exchange traded market.

Avoid complex option strategies at the outset. There are many companies willing to sell structured risk management solutions to producers or large consumers that are "designed" to better align with your specific risks. While some of these structures may in fact be effective risk management solutions, we recommend gaining a thorough understanding of simpler financial tools before adding this level of complexity. A three-way option strategy with an embedded binary may be the perfect tool, but if one does not have the resources to model or value the instrument, or cannot explain it to owners and management, it probably should be avoided.

Risk Aggregation and Reporting
Responding to changes in the pricing environment requires being able to accurately calculate and measure net position on a daily or at least weekly basis. Accurate and timely risk reporting is key to monitoring the effectiveness of a hedging program and informing decisions to alter strategies based on market events.

In addition, some simple metrics should be developed to evaluate how the hedging program impacts key financial metrics. "Cash flow at risk" can be a useful tool to assess the potential impact on changes in market prices to the cash flows generated by core operating activities. Other financial metrics such as gross margin, return on equity or return on capital are likely more actively monitored by management. Advanced financial techniques or complex modeling are not required to develop a simple scorecard to measure the impact of derivative hedge positions on these metrics on a forward looking basis.

Risk Governance
Finally, responsibilities for oversight and execution of the hedging program should be clearly documented and communicated to all, from the board of directors on down to the accountant settling invoices. A well-written hedge policy should be developed that contains delegation of authority limits and clearly defined responsibilities.

Key Communication
In the past few years, investors and other stakeholders have become much more in tune with how a company's hedging strategy can impact future returns. The ability to effectively communicate the intent behind a hedging program has never been more important. In addition, regulators are requiring increased transparency and better disclosure around how a company uses derivative instruments.

We believe hedging is a value-creating activity, in part because the penalty for getting it wrong can be so great in the form of substantially higher capital cost. However, many companies are still reluctant hedgers for fear that communication gaps with key stakeholders can lead to uncertainty or concern that investors may punish them if they depart from perceived industry norms, or "give away the upside." There also have been numerous highly publicized incidents of public companies suffering significant losses as the result of poorly designed and executed hedging strategies.

Despite these challenges, companies can still build effective hedging programs. Successful ones follow a disciplined approach requiring a strong understanding and communication of underlying risks, relevant hedging strategies, available tools, and associated valuation and reporting requirements. Developing a plan to communicate risk exposure internally and to manage perception and branding risk externally can be a key to successful hedging in the current environment.

Disclosure
Although the reasons behind hedging are clear to the company, they are often less transparent to investors and stakeholders. Recent changes to accounting rules and investor communication are now addressing this need for increased transparency. For example, the Statement of Financial Accounting Standard (SFAS) 161 now requires public companies to disclose much greater detail on the objectives for using derivatives, the context needed to understand those objectives, and strategies for achieving them. To be truly transparent, a company should also communicate what its long-term and short-term hedging expectations are, its hedging controls, and the company's skill set. Most importantly, the company should convey the long-term value of hedging as opposed to quarterly or even annual results that may place an undue focus on temporary market trends at the expense of multi-year risk management goals, metrics and successes.

Capital Constraints
Hedging can consume capital in the form of posted collateral, so any hedging program has to be developed in light of potential balance sheet constraints. Since the financial meltdown in late 2008, companies across the energy complex, large and small, must consider the impact of hedging on liquidity and capital resources. As noted above, many ethanol producers prefer to use OTC swaps, as these instruments have historically consumed less capital than futures contracts, which require both upfront and maintenance margining (collateral). New regulations contemplated by Congress, and expressed by the Commodity Futures Trading Commission, would require most swap transactions clear through exchanges, resulting in liquidity or collateral requirements similar to exchange-traded futures. Such regulatory changes will require evaluation of the impact from changing commodity values and processing margins in future periods in terms of potential collateral posting and liquidity; and the potential impact of collateral posting on other projects and initiatives that must be funded through scarce capital resources.

The bottom line is that ethanol producers need to consider a wide range of strategy alternatives and design hedging programs which protect working capital while balancing commodity risk management goals.
While hedging renewable fuel exposures can be challenging, companies can develop an effective hedge program by following a disciplined framework, and at the same time provide transparency to stakeholders through a well-thought-out communication plan. Starting out in hedging with a small volume of simple instruments, in well-developed markets, with relatively short tenors, will allow the organization to adapt financially and operationally. Balance sheet constraints and new derivative disclosure requirements also warrant careful consideration by management before the launch of any new hedging initiative. Once comfortable with your company's ability to deploy and manage commodity derivatives, more advanced concepts such as margin locks and dynamic hedging programs can be adopted with greater confidence and a lower risk of operational error. EP

Randy Wilson, Brian O'Neal and Evan Zuckert are managing directors of Eco Risk Markets LLC. Reach them at info@ecoriskmarkets.com.